To Cheer or Fear Rising Bond Yields?

Government bond yields have jumped over the past month or so, most notably in Japan and the U.S.

In the sense that rising yields herald a return to normal economic growth, this is a positive outcome. But there are also reasons to worry too that an excessively fast rise in yields could well undermine that same good news.

In a nutshell, that’s the QE conundrum. Central banks argue that their bond purchases are meant to push down yields in order to make long term finance cheaper. But, at the same time, a sign that QE’s working is rising yields.

For central bankers, the trick will be to ensure the rise in yields doesn’t cause growth to slow too much. One way to do this would be to put a ceiling on yields with aggressive bond purchases. The risk here is that in doing so the central bank is seen to be abandoning its price stability remit. Massive purchases, especially when governments are running deficits, could start to look like outright debt monetization. At a time when the wider economy is growing, this could act to over stimulate demand, threatening a big jump in inflation and possibly a currency crisis.

The Federal Reserve got a taster of this last week when the mildest of suggestions from Chairman Ben Bernanke that the QE program could be tapered later this year caused wider market ructions. For bonds, it was a double blow. Less QE implies stronger growth, which suggests higher future inflation. At the same time, it signals one of the big sources of demand for the bonds is pulling out of the market.

The U.S. 10-year Treasury bond yield is now at 2.19%, up more than half a percentage point on where it started the month and above its broad 1.5% to 2% trading range of the past year.

Now, in both the U.S. and Japan these moves have to be put in context. Yields are higher than they have been for a year or two, but they’re still very, very low historically. A ten year chart of U.S. 10-year yields shows barely a blip.

It would take another percentage point or so of rising yields over a relatively short period before pricier money would start to be a significant drag on the economy–and, of course, this would assume the economy’s upward momentum isn’t accelerating.

Even so, a Bank of Japan official made it clear the central bank would increase the frequency of its bond purchases to limit “excess volatility” of the bonds. In other words, they’d like to slow the rise in yields. In which case, the Bank of Japan should hope it can keep up with both the government’s issuance of debt as well as sales from the market.

But maybe investors should recall what happened at the end of the first and second rounds of quantitative easing in the U.S. Then, bond yields also shot higher with the withdrawal of the market’s biggest buyer, only to come tumbling back down when the lack of additional stimulus and higher interest rates caused growth to slow.